Revenue Standard: One Model, Two Approaches & Five Steps

The International Accounting Standards Board and the U.S. Financial Accounting Standards Board published a new joint standard on revenue recognition in May 2014, which comes five years after they published the first version of their joint revenue proposals. This replaces most of the detailed guidance on revenue recognition that currently exists under U.S. GAAP and IFRS. In particular moves away from the industry and transaction specific accounting guidance that existing under US GAAP and which in practice was also applied by IFRS preparers in the absence of more specific guidance under IFRS.

Reaching a common ground and finalizing a joint standard on revenue is a major breakthrough in the joint efforts for convergence of U.S. GAAP and IFRS. This will also usher in an era of global convergence on reporting on revenues, and it’s only a matter of time before Indian companies start following these new principles on revenue recognition.

What’s new: One Model, Two Approaches and Five StepsOne Model: The new standard brings in a single model for revenue recognition: so be it sale of goods, rendering of services, constructing contracts, licensing arrangement, all transactions will follow a single model that applies to contacts with customers, and will be used for revenue recognition.

Two Approaches: The standard also brings in two approaches to revenue recognition – at a point in time or over time.

Five Steps: The standard also brings in a five step approach that is applied to all contacts to determine whether, how much and when a company should recognise revenues. The five steps are:

1. Identify the contract with the customer2. Identify the performance obligations in the contract3. Determine the transaction price4. Allocate the transaction price to the performance obligations5. Recognise revenue when or as each performance obligation is satisfied

Also the standard contains some new guidance which may impact current practice, including the following:

Use of a control-based model as against a risk and rewards model under earlier guidance. However, the concept of risk and rewards has been retained as being an indicator of transfer of control.

Consideration is measured as the amount to which the entity expects to be entitled, rather than the fair value

Additional guidance on separation of goods and services in a contract

Additional guidance on recognising revenue over time

The application of the standard would also require significant application of judgement and estimates, including on estimating the variable consideration to be recognised, separation of the goods and services, identification of performance obligations, and estimating stand-alone selling prices. Some of these maybe extremely hard to apply when dealing with new products and services.

The standard also requires companies to provide extensive qualitative and quantitative disclosures to enable users of financial statements to understand the nature, amounting, timing and uncertainty around recognition of revenues and related cash flows arising from these contracts with customers.

Impact on companiesThis is a significant development as this standard has revised the concepts relating to one of the most fundamental and probably the most significant element of financial reporting, i.e., revenues. Companies will now have to evaluate the requirements more closely given that the final standard has been issued. However, there will be several implementation issues to be tackled along the way.

The new requirements will affect different companies in different ways. The timing and quantum of revenue recognition could vary for complex arrangements with multiple deliverables or components and/or variable amounts of consideration, or when performance under the contract is carried over an extended period of time, with the revenues recognition being accelerated in some cases and deferred in some others. For several other companies, it may result in a pattern similar to their current accounting. Companies in the telecom, engineering, construction, engineering, real estate and those that have bundled offerings of products and services could see a significant impact on revenue recognition.

Given the pervasive nature of the new standard, in addition to the financial reporting impacts, companies will also have to assess impact on other stakeholders such as investors and analysts. Companies would also have to determine the impact of the standard on areas such as tax planning, compliance with loan covenants, incentive plans, etc. This would also require changes to systems and processes including, sales and contracting processes, IT systems, internal controls, etc.

Effective dateThe new standard takes effect in January 2017, although IFRS preparers can choose to apply it earlier. While the effective date may seem a long way off, decisions need to be made soon – namely, when and how to transition to the new standard. An early decision will allow companies to develop an efficient implementation plan and inform their key stakeholders.

The views and opinions herein are those of the authors and do not necessarily represent the views and opinions of KPMG in India. All information provided is of a general nature and is not intended to address the circumstances of any particular individual or entity.